Interest rates

Interest rates are in focus this week as we look to the Monetary Policy Committee (minus anyone who might ever do macro or monetary policy research) OCR decision, and accompanying Monetary Policy Statement on Wednesday.    No one seems to doubt that the Reserve Bank will cut the OCR this week  (on the radio this morning I heard one of the historically most hawkish of the market economists being interviewed – who only a year ago was articulating the case for a higher OCR – and sounding quite relaxed about two more OCR cuts this year), so the real focus will be on the messages the MPC tries to send about what they might do in future if (unlikely event, as ever) things unfold as they expect.   And perhaps on which risks and issues they choose to emphasise.  I wonder if they will acknowledge that their relatively upbeat GDP forecasts earlier in the year relied on a strong acceleration in KiwiBuild –  of which there is little or no sign.

As week succeeds week, interest rates have generally been moving lower. But it is easy to lose sight of just how large the change has been.  I mostly use the Reserve Bank’s tables, and latest spreadsheet covers the period –  only 19 months –  since the start of 2018.    At the start of last year, the New Zealand 10 year government bond rate was 2.77 per cent.  Today, it is about 1.31 per cent.    That fall was almost as large as what we observed in New Zealand over the course of 2008.

10 year interest rate swaps have also fallen very sharply, with yields down 150-160 basis points over the period.

And it isn’t that inflation expectations have been collapsing.  Here are the yields on the three longest maturity New Zealand government inflation indexed bonds.

2030 maturity 2035 maturity 2040 maturity
3-Jan-18 1.53 1.76 2.03
2-Aug-19 0.40 0.61 0.78

Over the course of 2008 the then only (8 years remaining) indexed bond dropped only about 40 basis points in yield.

With two (or more) maturity dates, one can back out an implied future short-term rate at some point in the future.  Thus, for example, the Reserve Bank publishes rates for 10 year and 15 year interest rate swaps, which enables one to back out a implied five year rate in 10 years’ time (ie the period between the 10 and 15 year maturities).  At the start of last year, that implied forward rate was 3.89 per cent.  On Thursday (the last date for which the Bank has published numbers), it was 2.42 per cent (and the 10 year swap looks to have fallen another 15 points since then, most of which is likely to be reflected in the implied forward rate).    Something no higher than 2.3 per cent –  allowing for term premia perhaps something nearer 2 per cent – now looks like the best market guess at the long-term future OCR, when all the short-term cyclical factors are stripped away (no one forecasts cyclical factors 10 years plus ahead).

Incidentally, while those New Zealand yields are low by our standards, and have fallen a very long way over the last 18 months or so, they still look quite high by international standards.   Without a Bloomberg terminal (or something comparable) swaps data can be hard to find, but as far as I could tell 5 year forward rates 10 years ahead are still higher than those in Australia, the US (even though they currently have a higher policy rate), the euro area, Japan, Switzerland, Sweden or Norway.     That has been the New Zealand story for decades – our yields are typically higher than those in other advanced countries, for reasons not including commensurately faster productivity growth.  Low as our rates are now, and are expected to be, those gaps to other countries haven’t closed, and aren’t expected to.

We can do the same implied forward exercise using the indexed bonds on issue.    With a 21 year bond and a 16 year bond, we can back an implied 5 year rate in 16 years time: on Friday that would have been about 1.33 per cent down from 2.9 per cent at the start of last year.   That is a huge fall for an implied rate so far in the future.

With the 11 year maturity and the 21 year maturity, we can back out an implied 10 year rate in 11 years time.   That rate is 1.2 per cent.  The roughly comparable rate in the United States (implied 10 year rate in 10 years time) on Friday was 0.66 per cent.  Long-term real interest rates have fallen a long way in New Zealand, but are still well above those in the United States (and the US is a relatively yielding market internationally).

There was interesting, quite stimulating, article in the Financial Times last week on interest rates, headed “Profoundly low interest rates are here to stay“.   I wasn’t fully persuaded by all the author’s arguments (perhaps partly because he didn’t dig deeply into the question of why interest rates are so low in so many countries), but he ended with a couple of very useful points that are often lost sight of. First

this is not some perverse plot by Fed chair Jay Powell and ECB president Mario Draghi [or Adrian Orr for that matter]  to make life miserable for the world’s savers. The long-run real interest rate balances the desire to save and demand to invest. Central banks are its servants not its masters.

There are structural issues at play that are not adequately understood, perhaps around savings preferences, perhaps around demography, perhaps around productivity potential, perhaps aroud the optimal capital intensity of future production structures, perhaps…..(each of which have different implications).

I’m still sceptical of the idea that rates will remain low for ever: history would appear to be against that proposition

500 yrs

But the FT author’s final point is exactly right, and one too few central banks –  and probably market participants as well –  have heeded enough

it is time to stop waiting for rates to recover and face the world as we find it.

Including the fact that on current technologies, short-term official interest rates cannot be taken much lower in most advanced countries, and can’t even be lowered much in historically high interest rate countries such as New Zealand.

11 thoughts on “Interest rates

  1. Does it worry you that if (when) there is another financial crisis then we and the world have nowhere to go with interest rates?

    US and Australia are or near record stock market highs, employment is good. Seems lowering interest rates to stimulate the economy is not really necessary. I can see the point about following overseas rates tho – so its not a criticism of NZ – rather the US and others.

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    • On your first sentence, yes it worries me greatly. But that is partly why I favour pro-active use of what monetary ammunition is left. Were central banks to do nothing, inflation expectations would drift further downwards and then central banks would be having to cut just to stop real rates rising.

      Bear in mind that in the US, Aus, and NZ – and most other advanced countries – inflation is below target and in much of the world PMIs are already in contractionary territory (for various reasons).

      In NZ, some commentators think we will see unemployment rising in the release tomorrow (sounds plausible to me, but I don’t do those sorts of short term data release forecasts). Unemployment is typically a lagging indicator of an economy that has already been losing momentum.

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  2. The world is full of debt (future consumption bought forward), so the total money supply around the globe is excessive and thus the value of money (interest rates) are low. This is even more pronounced given the banking system is fractional (leveraged) and every dollar borrowed does not need to be backed by a dollar saved.

    I’m somewhat skeptical that the globe can dig its way out of the hole its in given just about every major economy has total debt to gdp > 100%. We only need 1 major hiccup to blow those ratios out of the water.

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    • I disagree with your take on what fractional reserve banking means. In fact, every new loan creates a new deposit, and need not alter either savings or investment. If inflation does not pick up, we can assume that S/I balances haven’;t changed much.

      Also worth remembering that in many/most countries, private debt ratios are not higher than they were in 2007. The fiscal situation is very mixed – mostly large countries with high and/or rising debts, but most advanced countries have pretty low and stable public debt.

      But….the next downturn is not going to be pretty, economically or politically.

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      • The leverage issue is important.

        For a simplistic example:

        For every $1 deposited and a 50% capital requirement, the other 50% can be loaned out (& then for the 50% loaned out, there is another 50% capital requirement & can loan out 50% again etc etc etc) the debt series sums to $1.0 and the capital series sums to $1.0 So from a $1 deposit the system can generate $2 in total. Debt/capital = 1/1 = 1x debt leverage.

        For every $1 deposited and a typical 15% capital requirement & the other 85% loaned out the series sum roughly to debt=5.08, capital =0.176, and debt/capital ratio = 28.8x

        At 20% capital requirement the leverage is roughly 3.82/0.25 = 15.3x or half that at 15%

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      • Unfortunately that is a lot of misinformation. Contrary to what you think financial transactions do not work the way that you think. Fundamental to all banks is a fully audited Balance Sheet. In order to create a Balance Sheet,ie it has to balance or net out to zero. If it does not add net out to zero it is usually called fraud or ponzi which usually leads to someone going to jail. Sure some people like Madoff got away for many years with billions unbalanced but eventually the law caught up with him for fudging his non existent investments.

        Always remember, Equity plus Retained Earnings = Assets(mainly borrowers loans) less Liabilities(mainly savers deposits)

        The 15% Equity you refer to is the net difference between the assets less the liabilities. Go look at a published financial accounts of say ANZ bank.

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    • I’m no banker – but – There are two different arrangements here

      1. The lending and receiving banks are separate – transaction is external
      2. The lending bank and receiving bank are the same – transaction is internal

      In example 2 situation is zero sum – nothing changes

      In situation 1 the receiving bank can escalate its lending while the lending bank has to unwind its escalation
      Situation remain neutral

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      • What is off balance sheet that can have enormous banking liquidity implications are what is called the derivatives market. These are the interest rate swap or the foreign exchange swap markets where there is no physical movements of cash settlements but is completely contractual. These are more like the old promissory notes where contracts are drawn up for a transaction event to occur in the future and then traded between different banks. It has a domino effect as these contracts are traded and the chain of banks could involve a dozen different banks. If one bank fails to meet its obligation then all the banks that have traded that contract also are not able to meet their obligations.

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  3. Interesting to contemplate what if any effects the rate cut will have. At these lower rates there must be a decreasing effect on demand for money from each cut? And if the result is just propping up asset values and not contributing to productive investment or stimulating spending, how does that help the economy?

    As an aside, RBNZ currently provides overnight interest to banks on surpluses above their Tier at OCR-1.0%. If the OCR drops to 1.0% or below, will they start changing Banks for having these overnight cash surpluses?

    Looking forward, when are RBNZ going to address (and tell us) what monetary policy is appropriate for OCR below 1.0%?

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    • don’t forget the exchange rate channel – all else equal, if the RB wasn’t cutting the TWi would be higher.

      it will be interesting to see if the RB keeps that margin for the above-tier settlement balances. I suspect they will – otherwise it would really signal that they didn’t have much confidence at all in being able to take any rates negative.

      Ideally, (and long overdue) they would use this week’s MPS to open up (not close down) a dialogue about options for future macro stimulus.

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